What a week – and it’s only Tuesday
European politics and economics were quite ‘exciting’ over the past days. The elections in Italy brought the expected outcome, with a former (?) neofascist ready to become Prime Minister; however, an overwhelming election victory it was not, with the right-wing alliance getting 44% and a large majority in both chambers of Parliament only because of a divided centre-left of Italian parties. Indications so far are that the new government will not do anything too crazy, but only time will tell. In any case I am less worried than I would if Marie Le Pen had won the French presidential elections, given that the Italian prime minister is much less powerful than the French president (at least with current constitutional arrangements). And Italy has strong institutions, among others in the form of a rather powerful president (more than his ceremonial role seems to suggest). But there is the risk that it will put the ECB in an uncomfortable position if spreads on Italian sovereign bonds get out of control again in reaction to crazy policies.
The UK in the meantime has shown how to best crash a currency. The economics behind it is very easy (indeed on the level of an A-level economics course or the MBA economics course I used to teach): Brexit (and the strong reduction in labour supply it has brought) has reduced potential GDP (long-term aggregate supply) and the economy seems currently to be at full capacity (judging from the unemployment rate and labour shortages). Fiscal expansion will push up aggregate demand beyond potential GDP and result in inflationary pressures. Pretending that tax reductions for the well-off will increase aggregate supply are simply illusionary. And even if the other policies suggested by the new government will increase aggregate supply, this can only happen in the medium- to long-term. However, I very much doubt that getting rid of environmental and labour regulations will help increase potential GDP; the easiest way to increase it would be to re-join the Single Market and the Customs Union and that is obviously not on the table. Rather, there is still the risk of a trade war with the EU if Liz Truss insists on the Northern Ireland Bill undermining the Northern Ireland Protocol and thus breaking an international treaty. Add to this a large current account deficit and the fact that the UK relies on the ‘kindness of foreigners’ to finance its current and now increasing level of government debt and it is clear why the British pound has depreciated heavily. As I said in my previous post politicians might be able to fool voters (and the right-wing media) but certainly they cannot fool the markets.
The Bank of England as independent monetary authority has stayed calm (in good English tradition?), but their statement on Monday evening suggests that it might be reluctant to raise interest rates too quickly in an attempt to off-set the pressure on the British pound that the fiscal expansion has caused. Another clear example that the independence of central banks has its limits in a country with no written constitution and where the previous government has trampled over long-standing norms and customs thus undermining the same institutions that are now so urgently needed. Either way, the bill for the reckless fiscal expansion will be paid by a large majority of the British population in the form of higher inflation (due to the depreciation and thus higher import prices) and/or higher interest rates translating into higher mortgage costs. What a way to run/ruin an economy!
Comparing the market reaction to the Italian elections and the UK mini-budget, the world seems upside down – muted reaction to a new right-wing government in Italy and strong reaction to the UK fiscal policy follies. I am old enough to remember when UK politicians and media declared in March 2020 that the impact of Covid-19 would never be as bad in the UK as in Italy, because the UK is so much better than Italy…. It was a deranged statement then and it seems even more deranged now, when looking back!
27. September 2022
Europe’s path to the future: challenges and opportunities
I was recently invited to discuss “Europe's pathway to the future: challenges and opportunities” – a very general title, which I took as opportunity to put together some general thoughts about economics, politics, finance and “what has the EU ever done for us”.
Politics vs. economics
It is a longstanding belief among economists that economics trumps politics. Put differently: politicians might be able to fool voters but cannot fool markets. Examples are ample: decisions during the eurodebt crisis taken late on Sunday night were soon dismissed by the sovereign debt markets as insufficient and resulted in further support packages soon after. You can also see it in the reaction of exchange rate markets to the Brexit referendum and – over the weekend – the budget plans of the new PM – markets are not convinced and have incorporated a risk premium for the UK, something that even the Tory spin doctors cannot explain away.
Economists, however, have learned that economic policy decisions can have important effects on the political environment, which in turn affects economic policymaking. As Jean Claude Juncker’s once said: we all know what is the right thing to do, but we don’t how to get re-elected afterwards. The rise of populists across the globe has been related to economic growth being linked to rising inequality, something that has become even more striking after the Global Financial Crisis. Or as the former Chief Economist of the Bank of England Andrew Haldane found out when he discussed GDP data in the North of England and someone in the audience told him: that’s your GDP not ours. And this populist backlash in turn can influence economic policy making, mostly to the worse: Trump’s tariffs on China, Greece flirting with sovereign default and the Brexit referendum all had negative effects on the respective economy and ultimately the people who voted for these decisions
However, there are also moments when politics trumps economics and the current crisis is one of these. We cannot sacrifice peace on the altar of cheap energy prices no matter how cold the winter. We cannot sacrifice human rights on the altar of global supply chains, no matter how efficient they are. Freedom and peace always trump the laws of economics; something we might have forgotten over the past decades but what the struggle of the Ukrainians have reminded of us. Maintaining freedom and democracy should be important constraints for any economic policy decisions.
It also provides important lessons for externalities imposed by some member states on others. During the eurodebt crisis in the early 2010s, there was a lot of (partly justified) criticism of some periphery countries imposing stress on the euro area due to their boom-bust credit cycles and sovereign overindebtedness. Now we are in a similar situation: As Thomas Philippon has pointed out, Germany and other European countries have imposed externalities on the rest of the European Union by making themselves too dependent on Russian energy. So, there is an important lesson here: If you think you own the moral high ground during one crisis, you might want to be careful with throwing stones as you might end up in the glass house during the next crisis. Solidarity towards others in one decade might have to be reciprocated the next decade.
Markets vs. social objectives
As Isabel Schnabel pointed out in her Jackson Hole speech last month, the period of the Great Moderation seems over and we might be entering a period of the Great Volatility. While economists do not have a good track record in predicting events, I am rather convinced that the pandemic, Ukraine war and energy crisis will not be the last shocks this decade will see, both on geopolitical grounds but also on the account of climate change. A sudden return to 2% inflation or below seems rather illusionary under current circumstances. And even though tight monetary policy might not be the best tool to address supply-side shocks, it is important to keep inflation expectations anchored. At the same time, there is a case to be made for a stronger role of fiscal policy, especially when it comes to distributional implications of this shock. One important positive development during the Covid crisis was the launch of the Next Generation EU package, recovery package in what I called a Hamiltonian glimpse at what kind of European fiscal policy is possible. Given the continuous shocks and crises Europe has been facing, I very much doubt this will be a one-off and it should not.
The Covid crisis has clearly put shown the important role that governments have to play during crisis periods, as insurer of last resort. And as during the Covid crisis support for the real economy during repeated lockdowns helped the private sector recover quickly afterwards, the role of government in helping during an energy crisis and avoid people freezing to death is an obvious one, in my opinion. The question, however, is how to go best about it.
Many economists, including this one, would argue that simple price caps for energy prices are not useful. We need price signals even if we don’t like them, both on a personal level and for society. I would therefore argue – as suggested by Isabella Weber, a German economists in the US- that a price cap up to a certain consumption threshold representing the needs of a representative household – or transfer payments to off-set the negative impact of high energy prices of low-income and middle-income households would be more useful, more efficient and much less costly. Another interesting recent proposal has come from the Bachmann et al. group, giving households a credit in the amount of energy consumption during the last winter, which gives households then the choice how much energy to use. High energy prices signal scarcity; eliminating the function of such price signals to reduce demand might have the negative result of necessary wide-spread rationing.
The role of finance – beyond bailouts
The European financial sector has performed much better during the past three years than many expected; among the reasons for that, two stand out, in my opinion: one, the post-2008 regulatory reforms that have strengthened the resilience of banks; two, the support programmes introduced by governments across Europe in spring 2020 that affected the financial system indirectly. And as reassuring as it might be that the financial sector is not at the core of either Covid nor Ukraine/energy crisis, it is important to stress that it still has a critical role to play in helping the resilience of the real economy. And even though many of the support packages are on the national level, it is important – again – to maintain the Single Market in banking, which allows for proper risk sharing and allocation efficiency. It is also important to stress that banks and other financial institutions and markets will have an important role in the reallocation process, away from energy-intensive sectors, but also towards more resilient supply chains. A strong and efficient financial sector is thus critical for both minimising the effect of a coming recession as for a robust recovery.
Talking about a Single Market in Banking, everyone here is aware that we are still far from it. We still have German banks, Italian banks, French banks. Out of the original objectives of the banking union project, none has been achieved completely: resolution with bail-in – barely; sovereign-bank link: alive and kicking and only kept in check by the ECB ; European banking: we are seeing rather a retrenchment towards national markets. And so at the risk of sounding as repetitive as the Elder Cato, let me stress that I think that the banking union has to be completed and hopefully before the next financial crisis, whenever it comes.
But even that would be a necessary but not sufficient condition for a truly European banking market – another important element is of course the politics. And we see it here in Italy, Monte dei Paschi, or in Germany, with the ill-conceived idea of a merger of Deutsche and Commerzbank. For better or worse, banking will always be close to politics, but I would argue it might be better on the European than and the national level.
What has the EU ever done for us?
When academics discuss (or rather criticise) policy decisions, their counterfactual is often a world without political tensions. As I have critically accompanied the construction of the banking union, I have often been guilty of this approach.
However, there is an alternative counterfactual. Imagine the Covid vaccine roll-out in 2021 without the EU, imagine the Western European sanction policy without the EU, imagine the current energy crisis without a common European energy market – a rather nightmarish scenario of constant conflicts between 27 nations. We live indeed in very volatile times, but working within the European framework gives our part of the world an enormous advantage compared to previous centuries.
The important thing to keep in mind that the macro-level European politics has to be supported on the grass-root level. European citizens have to see the benefit of European integration. In this context, the UK might have done the EU a favour with Brexit – people in the UK are less likely to link inflation and recession to Brexit (given many other recent developments) but clearly live the Brexit of little things, the Brexit of daily life: long passport queues, customs duties for packages coming from the EU, roaming fees when abroad.
So, I think it is important to keep in mind and alive the benefits of European integration in daily life and the unity on the political level. Which gets me back to my starting point: politics and economics go hand-in-hand. The political support for the EU goes hand in hand with economic benefits, both on the level of voters as on the level of governments.
26 September 2022
Elizabeth II
One does not have to be a royalist or monarchist to be touched by the passing of Queen Elizabeth II after 70 years on the throne. And one could have thought that this would be a moment of national reflection on how much the country has changed over the past seven decades and the challenges ahead. However, it seems it has rather been used by the political class to silence an important discussion on how to address the economic, political and energy crises the country faces. And even worse, this reflection on the past 70 years has now given space to ugly scenes of a rising police state where even holding up the sign “Not my King” constitutes breach of peace, resulting in arrest, and where holding up a white sheet of paper triggers policy action.
Ultimately, this reflects the UK after 6 years of Brexit chaos. To avoid any serious discussion on what has gone wrong and how to address the crisis, politicians and media hide behind wall-to-wall reporting on national mourning and the new King (not to forget about the role of Harry and Meghan). It seems the country has been suspended for ten days, mourning the loss of a monarch that linked it back to the Empire and the more ‘glorious’ days of British history. It is clear that in the coming years the country will have to face a reckoning, the question is how long it will take to get there.
18. September 2022
Ieke van den Burg Prize 2022
The Ieke van den Burg Prize, an annual prize to recognise outstanding research conducted by young scholars on a topic related to the ESRB’s mission, awarded by the Advisory Scientific Committee, was this year given to two papers, both of which address very timely topics.
The first one – especially close to my own interest - studies the effects of bank payout restrictions, imposed during the COVID-crisis in 2020 on banks’ risk-shifting incentives. Thomas Kroen uses the fact that only Fed-supervised bank holding companies were subject to the ban on share buy-backs and restrictions on dividend payments in the US. He finds that both equity prices and CDS spreads and bond yields declined for these banks, suggesting that that payout restrictions shift risk from debt towards equity holders. After restrictions were lifted, both effects reverted. Overall, this suggests that pay-out restrictions reduced risk-shifting incentives of banks, in line with the intention of supervisors. Thomas also provides micro-evidence for this effect by considering syndicated lending data and shows that banks increase their non-investment grade lending by 32 % relative to investment-grade lending when the payout restrictions are removed, while the average interest rate spread declines. Finally, he provides back-of-the envelope calculations that the financial safety net guarantee by the government also reduced in the value during the period of payout restrictions, i.e., the amount of bailout resources the government would have to provide in case of bank failure times failure probability. Overall, quite powerful evidence in favour of payout restrictions during extreme crisis situations such as in 2020.
Antonio Coppola shows the importance of investor base composition for the performance of firms during financial crises. Fire sales by investors might put pressure on firms and their access to external funding. This has raised the focus on long-term investors as safe hands, in contrast to weak- hand investors who are prone to quickly liquidate their investments in times of market-wide distress. Antonio focuses on two investor sectors, insurance companies and mutual funds, which are the most important participants in the corporate bond market. Given that mutual fund clients can redeem capital easily unlike insurance policy holders, mutual funds have a higher propensity to engage in fire sales than insurers. He finds that this matters for firms. Specifically, firms whose bonds are owned by mutual fund investors and who are thus less prone to fire sales face relatively better credit conditions: they maintain higher levels of borrowing, pay a lower cost of capital, and have higher real investment rates. He uses large-scale security-level holdings data and introduces issuer fixed effects, i.e., comparing a firm’s bond held by either an insurance company or a mutual fund, to control for endogeneity. The economic effects are also strong: All else equal, increasing insurance holdings in a bond by 50 percentage points leads to price declines during downturns that are 20 percent shallower; further, firms at the 90th percentile of the distribution of bonds held by insurers have capital expenditure rates higher by 1.5 percentage points than firms at the 10th percentile, are 25 percentage points more likely to issue new bonds in each of the crisis years, and pay offering yields lower by 120 basis points when doing so. These findings are important for ongoing macroprudential policy discussions, such as on gating provisions for mutual funds during crisis periods but also the need for a diverse institutional investor base (with mutual funds being able to provide liquidity during normal times but insurers reducing the risk of wide-spread fire sales during crisis situations).
31. August 2022
Ukraine and European integration
Together with my colleagues Maria del Carmen Sandoval Velasco and Pierre Schlosser I wrote a short policy note on the impact of the Ukraine invasion on European integration. Well known to political scientists, Monnet’s method posits that reforms and new European structures and powers are driven by adverse events and crises that cannot be solved with existing policy tools and on the national level. The eurodebt crisis has brought us the (incomplete) banking union and the Covid crisis the Next Generation EU, a joint fiscal response which I referred to earlier as Hamiltonian glimpse at what might be feasible in a fiscal union. Similarly, the Ukraine crisis will have repercussions for actors, instruments and rules, as we discuss in our note. Concerning actors, the European Commission seems again in the position of taking on new crisis management responsibilities, even though security is not its area of expertise; the ECB will, on the one hand, be struggling with higher inflation, while at the same time, becoming again pre-occupied with sovereign yield divergence in the euro area. For the first time, the SSM will have to take geopolitical risks clearly into account in its risk monitoring, while the still to be created Anti-Money Laundering Agency will take on an even more important role. Concerning instruments, while the EU has played second violin to NATO, a total of €1.5 billion of military assistance has been agreed at the European level to support the Ukrainian army, which constitutes a new policy area for the EU. While the cohesion funds might take on a stronger role (with necessary flexibility to reallocate funds approved by the Commission) as economies across Europe are differently exposed to the conflict and rising energy prices, there is still discussion on an NGEU 2 to help with the reconstruction of Ukraine. Finally, concerning rules, the conflict has made clear that the Stability and Growth Pact – suspended since spring 2020 – needs an urgent revamp and redefinition although politics might only allow for further suspensions. Similarly, the suspension of state aid rules might have to be extended, at least for some sectors in light of a looing energy crisis.
In summary, this crisis will have important implications for the European Union on different levels and we will certainly see more actions and reforms in the coming months.
8. August 2022
Hot summer, desperate autumn
As Europe suffers from a heat wave that has been predicted for 2050 rather than 2022, the politics across Europe has taken again a shift for the worse.
In Italy, the populist parties have put an end to Draghi’s technocratic government. Early elections and a stop to pass the necessary reform legislation might hold back further funding from NGEU and the economic recovery. The perspective of a right-wing government, led by a formerly fascist party does not exactly raise confidence either. At the same time, the ECB faces further pressure to fight inflation and sovereign fragility at the same time; as before, Italy will provide the proof to which extent this can work. The new programme (Transmission Protection Instrument, also known as To Protect Italy) has the potential to reopen the political tensions between North and South. At the same time, a new conflict has been opened, between countries that have created energy dependence on Russia over the past decade (most prominently Germany) and others (such as Spain). In the other main European countries, things do not look much better. President Macron lost his parliamentary majority (on the upside, this increase in checks and balances might make reforms more sustainable). In Germany, Olaf Scholz is still struggling with the Putin-friendly wing of his own social democratic party. At the same time, Hungary’s regime is going a step further and trying to cosy up to Putin as much as possible.
In the UK, Liz Truss is seen as favourite to become the next Prime Minister – as a late convert to Brexit (she strongly supported Remain) she is even more extreme than others in the Tory party (also known as English Nationalist Party), a similar trajectory as Lord Frost. The two candidates Rishi Sunak and her are currently engaged in an arms race of who can be nastier to refugees, who can give more money away to billionaires while cutting public services even further and who will take a stronger stand against the EU. As pointed out by numerous observers, most elegantly Chris Grey, this will only end in more tears as either of them will try to convert these promises into actual policy, which will again prove impossible. And all of this on the background of more Brexit disruptions, as British tourists trying to cross into France in Dover discover yet again how Brexit has not made their life better, with hour-long waiting queues. Obviously, the British have to blame the French for this (French immigration is done in Dover and on one specific morning, French officials were delayed by a total of 1.5 hours); ignoring the fact that the British government refused to expand immigration facilities in Dover ahead of Brexit – so, the usual patterns: Brits refusing to take responsibility for the consequences of Brexit and their refusal to properly prepare and blaming others – no wonder no one takes the UK serious anymore.
A good moment to take a few weeks off and getting ready for a rather hectic autumn. On the upside, I have just discovered a great restaurant in Bogota – Leo – which – if the Michelin guide were to cover Colombia – certainly would qualify for a Michelin star.
24. July 2022
Fighting energy price inflation
The Russian aggression against Ukraine has further fuelled an already high energy price inflation. There is an intensive debate on how to mitigate the impact on households, especially lower-income households. One politically popular suggestion to mitigate the impact are price caps, which would benefit all consumers; however, this would not entice them to reduce energy consumption and – in the worst case scenario – might result in rationing. To avoid such rationing, one could impose a more limited use of energy (such as car-free weekends in the 1970s during the first Oil Price Crisis– one of my first memories as child growing up in Hamburg). At my university, we are told to use air conditioning only between 10 and 3; however, this is not being monitored, which raises the general challenge of monitoring caps of energy usages. That’s why economists prefer the power of market pricing. But what if energy use is price-inelastic for certain ranges of consumption? To off-set rising energy costs for consumer, transfers have been proposed. However, such transfers would have to be targeted at low-income households and involve an administrative burden (can all low-income households easily be reached, especially if they do not pay income tax?); in addition, there might be a time gap between energy bills and transfer payments, which poses problems for liquidity-constrained consumers.
One intriguing suggestion comes from Isabella Weber and has been picked up by others: a price cap up to a threshold and market prices above. This threshold could be set such that the energy consumption covered by the price cap corresponds to the basic needs of a household. While all households would benefit from this price cap, the administrative burden of proper targeting or transfer payments would not be incurred. And incentives for energy savings would still be in place above the threshold where market prices would rule. Taxpayers would have to compensate energy companies for what is effectively a social transfer. . And finally, such a price cap has the positive macroeconomic side effect of mitigating pressure on a price-wage inflation spiral. On a broader note, one can see such a quantity-limited price cap also as a tool for the transition towards net zero.
Overall, an adequate policy for extraordinary times, combining social and market into a policy tool.
23. July 2022
The clown leaves, the circus continues
When Boris goes, Brexit goes, some observers have noted. But fear not, the Brexit soap opera will continue for many more seasons. I even would bet that one of the main protagonist, BJ, will continue to feature heavily, possibly as newspaper columnist spreading stab-in-the-back conspiracy theories and explaining to the world who prevented him from implementing the true Brexit. But if anyone thinks that the Tories would turn sensible and real world oriented, they will most likely be in for a ride, as after all the Tories are heavily invested in this soap opera as is the sycophantic press that supports them. To the contrary, we might see a further hardening of the Brexit stance under the next Prime Minister, with a passing of the NI Protocol Bill (which breaks NI Protocol, part of the UK Withdrawal Agreement, and thus international law) leading to a trade conflict between the UK and the EU.
There has been a clear downward trend in the quality of Prime Ministers since Gordon Brown left office in 2010. David Cameroon embarked on the ill-advised austerity drive (which helped the Leave campaign win in 2016 by promising to recover public services with money ‘saved’ from EU contributions) and gambled the future of the UK with a Referendum that had only one objective: resolve an intra-Tory conflict that not many people cared about. While he had little of an ideology, his successor Theresa May did: an explicit hatred of anything foreign, ‘nicely’ summarised in her Citizens of Nowhere speech, copied from no other than the Master of fascist hatred, Adolf Hitler. Her attempt to schmooze with ultra-Brexiteers by drawing red lines (control over laws, border and money ) without any plan on how to go about it forced her later to back-pedal and led to her downfall, as hers was not the true Brexit. A failure on all dimensions, ‘pissing off’ everyone, including remain voters, EU citizens in the UK, ultra-Brexiters and the EU, without achieving anything
Enter Boris Johnson, the worst Prime Minister of the three and possibly in UK history, an incompetent liar, cheater and gambler with no beliefs but narcissistic self-confidence. Signing an international treaty that he never intended to honour, breaking the laws and rules he announces on TV and lying about it afterwards. I do not want to waste any more virtual ink on this despicable human being, but just note that there is no guarantee that the next PM will be any better and there might be a chance she will be worse; just think of Suella Braverman. In any case, as in any good soap opera, we will now see a repeat of the 2019 Tory competition, where candidates will outbid each other on who is the most radical Brexiter in the country. More broadly, we will see the political conversation yet again turn completely inward, as it was between 2017 and 2019 during the Brexit negotiations, where the UK was so busy negotiating with itself that there was little space to actually negotiate with the EU.
As Janan Ganesh points out, the UK has become a tragicomic country. The best-case scenario is that it will economically (and politically) become a Mediterranean per capita income with northern European weather, as Janan argues. I would add that the worst-case scenario is that it follows the example of Argentina, the only country that went from being a high-income country to a middle-income country in the 20th century. While this is certainly a rather long way off and might sound a bit too pessimistic, the damage done by the Conservative Party over the past 12 years will be hard to reverse. A UK return to Single Market and/or Customs Union seems off a couple of decades and not just because Labour does not want to open the debate on it, but also because it is hard to imagine that the EU will accept such an entry any time soon.
The UK is truly on a downward trend and it is hard to see when it will hit bottom. In the meantime for those of us who have left the UK, we continue to watch the soap operate with amazement.
11. July 2022
Europe’s energy policy in the wake of Russia’s aggression
The invasion of Ukraine by Russia has transformed the European energy crisis, which had already started in summer 2021, into a structural one. Several of my colleagues at the Florence School of Regulation have written a manifesto on the best way forward, to address this crisis while working on mitigating the impact of the climate crisis: Between crises and decarbonisation: realigning EU climate and energy policy for the new “State of the World”. I was privileged to participate in the discussion and sign the manifesto, recently presented in Brussels.
The main policy conclusions can be summarised as: don’t give up on the market but use policy interventions to ensure a fair transition for Europe, especially the most vulnerable households. Regulating prices should only be used as last resort; targeted lump-sum transfers should rather be used to support the losers of the crisis and could be financed with a tax on windfall profits by the winners of the crisis. In the medium-term, there is a need for a strong focus on energy security of the EU, including the acceleration of using renewable energy and reduction of fossil fuel use and the build-up of a skilled workforce in the renewable energy sector. Finally, there is the need to build a future-proof energy market, which combines the role of price signals with reduced volatility for consumers. Most importantly, in spite of the many short-term pressures (and thus political temptation for short-term fixes) a clear long-term strategy is needed.
29. June 2022
Postcards from Florence
The last weeks have seen a couple of exciting workshops and conference at the Florence School of Banking and Finance.
First, a workshop discussed the role of artificial intelligence (AI) and machine learning (ML) in banking and finance and brought together academics, supervisors and consultants in this field. My colleagues Maria del Carmen has written up a summary of this discussion on the FBF blog. Here are some additional insights that I took away: when it comes to the use of AI and ML in practice, a robust data governance framework is needed. There seems a large gap between technical capacity and ‘explainability’ of the techniques, which has to be bridged and which requires humans in the loop. Put differently, it is not sufficient to simply use these techniques, but a degree of ‘explainability’ is called for (including towards senior management and board members). There is also a critical need to sensitise senior management to digital approaches (both benefits but also risks). Finally, one important lesson for supervisors is to take a critical view vis-à-vis the use of AI and ML in the institutions they regulate, while at the same time they increasingly are using such techniques themselves (Suptech and Regtech). Certainly a tension that has to be addressed carefully.
Second, our first Annual Conference in three years brought together practitioners, academics and policymakers to discuss topics in digital and green finance under the heading “The Future of Finance – Finance for the Future”. In her keynote and to set the stage, Anneli Tuomen (former Director General of the Finnish FSA and now ECB representative on the Supervisory Board of the ECB) pointed to the risks for European banks stemming from the Russian aggression and rising energy prices, but also the much stronger capital buffers that European banks have available compared to a decade ago. Further, European banks have come stronger out of the pandemic than initially feared. She also pointed to new sources of risks, including cyber-risk and increasing dependence of banks on third-party service providers (e.g., cloud services). The increasing digitalisation in finance was an important topic at the conference, including the increasing role of BigTech companies and new legislative and regulatory initiatives on the European level, including the new crowdfunding regulation. What are the implications for competition from an increasing role of BigTech companies? Discussions on digital currencies showed a clear contrast between regulators and practitioners who focus on potential uses and technical details of such currencies and academics who see little if any value added from digital currencies on the retail level (to be paraphrased as: ‘what problem is the digital euro the answer to?’). The transition to a sustainable financial system was a second major theme. To which extent can we rely on the financial system to undertake the necessary shifts in asset allocation and to which extent are regulatory tools needed, including stress tests or even adjustments in capital requirements?
Third, we had a fascinating Women in Finance workshop. Reuter journalists Brenna Hughes Neghaiwi and Tom Sims presented their recent research on the limited ascent of women in Europe’s banking system. One important reasons for this can be summarised as an implicit bias in recruitment: “Tim goes away, so who looks like Tim?... It's usually not a Sarah.” However, this bias and limited diversity comes at a cost, not only in the financial system, but also, as EUI’s Costanza Hermanin pointed out, in the public sector and political sphere. One important question is how to bring more women into leading roles; mentors seem to play an important. EUI’s Johanna Gautier discussed the strong of women in international financial institutions, with Ann Krueger having been chief economists of the World Bank back in the 1980s and later deputy managing director at the IMF. IMF, World Bank, EBRD and OECD all have had female chief economists. One explanation for the stronger role for women in these institutions might be that they require higher cultural sensitivities and have thus somewhat less space for the biases described above.
27. June 2022
Sovereign debt and financial stability
We had two events at the Florence School of Banking and Finance over the past two weeks on financial and sovereign debt stability. Joint with Georgetown University, Graduate Institute of Geneva and the Sovereign Debt Fund, we held the 5th edition of DebtCon last week in Florence, a fascinating interdisciplinary event with economists, lawyers, historians and political scientists, academics, practitioners and policymakers. As the world has been emerging from the pandemic, corporate and sovereign overindebtedness as consequence of the pandemic, lockdowns and government support measures has been of increasing concerns. With monetary policy in the US tightening (and at least a normalisation on the horizon in the euro area) and thus the global financial cycle tightening even more rapidly after the Russian invasion of the Ukraine, the threat of sovereign distress becomes more acute and is already happening in some countries, such as Sri Lanka. However, we were reminded that the current (corporate and sovereign) debt wave actually started in 2010, with global sovereign debt/GDP now higher than global corporate debt/GDP. If the fear of a global recession materialises, there might be further sovereign distress such as in some countries of the former Soviet Union and Central America and Caribbean.
Certainly a scary backdrop for the academic and policy discussions at the conference, but also an important impetus for research in this area, including studies of historical sovereign distress situations (or situations where default was prevented, such as Colombia in the 1980s), studies of the domestic and international politics of sovereign debt restructuring and attempts to improve data availability on sovereign debt and increasing transparency.
There are also new issues arising; most importantly, as my new colleague Sony Kapoor pointed out, the moral debt of advanced countries not only vis-à-vis their own future generations but also vis-à-vis developing countries having used up environmental space. At the same time, developed countries are encouraging their developing peers to go for high-initial-cost investment in green energy, which might not be feasible given limited access to international capital market. Given the nature of a stable climate as global public good, there is certainly a global deal to be made; given the current geopolitical situation, however, the likelihood of such a deal seems depressingly low.
Similar themes last Thursday, when we had an exciting online roundtable (jointly organised with the Center for Global Development) on Sovereign Debt and Financial Stability in Europe and Latin America. Several important messages came out of the discussion: first, there has been an increasing divergence in access to financing markets by sovereigns; the ability of countries to respond to the pandemic differed dramatically by their access to international capital markets. This, in turn, will also affect post-pandemic growth paths and whether or not countries can go back to pre-covid growth paths. This divergence might be further exacerbated with the current geopolitical disruption and the monetary tightening in the US. Interestingly, this can also be seen in Europe, where countries outside the euro area (but within the EU) have seen a faster increase in sovereign bond yields than countries inside the euro area. Second, there was a general agreement that price stability is a necessary (though not sufficient) condition for returning to a sustainable growth path. And even though supply-side induced inflation (as it might be primarily the case in the euro area) might not be influenced by monetary policy, inflation expectations will, which reinforces the argument for normalisation if not tightening of monetary policy in the euro area. Third, there is a clear difference between commodity exporters and importers in the economic effects from the dramatic recent increase in commodity prices; not surprising but important to keep in mind! Fourth, as interest rates increase, bank-sovereign fragility links will again gain prominence, including in emerging markets.
4. June 2022
Interesting papers – May 2022
One nice benefit of being able to travel again to conferences and seminars is that one meets interesting people with interesting papers. Here a small selection
Oliver Rehbein and Simon Rother make an important contribution to the literature on the role of social connections and distance in lending in The Role of Social Networks in Bank Lending. The authors use data from Facebook to construct indicators of social ties within the U.S. population across counties. Controlling for physical and cultural distances, social connectedness increases cross-county lending. On average, a standard-deviation increase in social connectedness increases cross-county lending by 24.5%, which offsets the lending barrier posed by 600 miles between borrower and lender. This effect is stronger for SME lending (where screening and monitoring is more difficult) than for mortgage lending, in line with theory. And social connectedness between counties is not associated with riskier cross-county lending. Further, borrowers’ counties tend to profit from their social proximity to bank lending, as GDP growth and employment increase with social proximity. Overall, social networks can thus help to overcome information frictions and improve bank lending, effects that are orthogonal to other measures of distance and can partly offset physical distance between borrowers and lenders.
Sebastian Doerr , Thomas Drechsel and Donggyu Lee show that rising income inequality can reduce job creation at small firms in Income Inequality, Financial Intermediation, and Small Firms. A lot has been written about the determinants of increasing income inequality in the U.S. and its consequences. Sebastian and co-authors focus on one specific negative effect of this rise in income inequality: as high-income households save relatively less in the form of bank deposits, a higher share of income accruing to top earners therefore undermines banks’ deposits base and their lending capacity for small businesses, thus reducing job creation. Exploiting variation in top incomes across US states and over time, they find that a 10 percentage point increase in the income share of the top 10% reduces the net job creation rate of small firms by 1.5–2 percentage points, relative to large firms. The effects are stronger at smaller firms and in bank-dependent industries, thus providing evidence on the mechanism mentioned above. Rising top incomes also reduce bank deposits and increase deposit rates, in line with a reduction in the supply of household deposits. While the political debate on income inequality often focuses on fairness and the rise of populism, this paper shows the important economic costs of rising income inequality.
Rainer Haselmann, Christian Leuz and Sebastian Schreiber provide evidence that German banks use knowledge acquired in lending relationships for trading purposes in Know Your Customer: Relationship Lending and Bank Trading. Universal banks combine lending business with investment banking and brokerage services, which might raise conflict of interests. However, it is difficult to find a smoking gun for information exchange between different parts of an universal banks. The authors do so, by combining detailed German data on banks’ proprietary trading and market making with lending information from the credit register. They then examine how banks trade stocks of their borrowers around important corporate events and find that banks trade more frequently and also profitably ahead of events when they are the main lender (or relationship bank) for the borrower. Specifically, relationship banks are more likely to build up positive (negative) trading positions in the two weeks before positive (negative) news events, and they unwind these positions shortly after the event. This trading pattern is more pronounced for unscheduled earnings events, M&A transactions, and after borrower obtain new bank loans. A back of the envelope calculation shows that on average, relationship banks earn an additional trading profit of €3,890 per event. These results suggest that lending relationships endow banks with important information, highlighting the potential for conflicts of interest in banking, which has been a prominent concern in the regulatory debate.
22. May 2022